Redefine your measurements to stimulate operational excellence

A difficult business climate as today’s provides corporations with an opportunity to take a hard look at their operational procedures to weed out inefficiencies that might exist in various business functions. Focusing on reducing waste and improving operational processes helps businesses in their journey towards attaining operational excellence. In addition, it also allows for cost savings, which can provide stability to the profit margins in adverse economic times as these.

Today most businesses have formal processes for continuous improvements in manufacturing and supply chain. However, often these improvement initiatives stop short of attaining their maximum potential because of the way people and processes are measured within the organization. Traditional accounting and operational measures sometimes come in the way of achieving operational excellence because these measures often promote waste such as excess inventory.

As an example, let us consider idle capacity. Usually idle time is considered bad, and as such higher machine utilization is considered good. Higher machine utilization is desirable only if there is sufficient demand to back up the supply created by a highly utilized machine. A machine operating 90% of the time and producing goods filling up warehouses (without any immediate customer demand), would have high machine utilization, but it would lead to higher inventory levels as well. In a lean manufacturing environment, a machine should run only in response to pull from customer demand; targeting a high utilization alone is contrary to that. As such, a better measure of utilization would be schedule reliability- what percentage of the schedule was met on time so as to satisfy the demand created by customer pull. Also, operating the machine only in response to customer demand would mean that flexible capacity is being created and machine maintenance could also be planned better.

Another traditional measure often used is the purchase price variance- the lesser the variance from the standard price, the better. Often suppliers give discounts for large order quantities. In order to use those discounts to keep procurement costs down, buyers place orders for larger than required quantities, or place orders for items that might not have immediate demand. This does reduce the purchase price variance in general, but this also adds to the inventory levels in the warehouse. In addition to the working capital that gets tied up, the administrative costs related to maintaining the inventory also goes up. An alternative measure for the buyer could be their contribution in right- sizing the inventory.

Another example of traditional costing measurements not providing the best results is in the factory overhead allocation. Overheads rates are usually determined based on maximum theoretical capacity, and the actual overhead costs within a period are pro- rated to each unit that gets manufactured irrespective of how much each product consumes the overhead. When profitability analyses are done by product lines/ families, this could inflate or deflate costs incorrectly for different products. Rationalization of product lines to limit the product offering based on product profitability is a lean principle that leads to better capacity management, reduction of inventory and increased flexibility. However, because of the way high overhead costs are pro-rated, the product profitability analyses could lead to erroneous results thereby hiding the non-profitable products.

An important underlying concept directly attached to on-time delivery is lead time. This is a common measure I have seen customers use across industries. They often measure their on- time delivery against the date scheduled by their ERP systems. To ensure on- time delivery,planners often build a buffer into the lead times so that ERP schedules it with some amount of safety built into the date. If a BOM consists of several levels, then a little bit of buffer in each components’ lead time would considerably inflate the parent lead time. Thus, components would be procured and made in advance of the actual time. This would also add to the inventory and might need rescheduling of the transportation activity. Having said that, on- time delivery is an important measurement and people are justifiably appraised on it, however, efforts should be made to ensure that lead times are not inflated just to get a good grade on on- time delivery.

Another way of looking at this is that traditional measures do not give due credit to those parameters that improve as an outcome of operational improvements. For example, a lean operation would lead to reduced inventory levels, reduced cycle times, increased working capital, reduction in bottlenecks etc.. However, even though these may be measured, they are not tied to any incentives. In my consulting experience, I have observed that employees are appraised on the traditional measures, and seldom on how much they have reduced inventory in a period while meeting customer demand, or what is the cycle time reduction a department has achieved, by what percentage has supplier reliability gone up, what is the schedule adherence for a line etc..

Operational excellence is a journey and the commitment to get leaner is an important part of that journey. However, backing this journey up should be appropriate accounting and operational measures that provide incentives for these initiatives. Traditional accounting measures usually serve the needs of the finance department, however, in modern day world, it should also serve the needs of a lean operational system.

The above are just some examples of measurements that need to be reexamined onb a case by case basis. Can you think of other such measurements that would create the incentives for operational excellence?